How Value Investors Could Prepare for a Stock Market Crash

It's that time of the year again where markets are plunging after a relative period of calm since Trump's election. This is not the first market drawdown we've lived through, and here are several thoughts on how investors can prepare when markets decline.

There is nothing intrinsically "wrong" about markets going down. Volatility is volatility - and it works both directions. Markets that go up continuously are not intrinsically "better" although it certainly feels good until the cycle turns again!

Markets have a strong tendency to overshoot on either side of the direction.

Businesses that are engaging in fraudulent behaviour (Enron, S-Chips aka China Companies listed in Singapore etc) can be market darlings for long periods of time. Eventually, one can only prolong the inevitable for so long before such corporates come collapsing down.

In the reverse situation, companies that are facing temporary difficulties eventually rebound as they overcome the challenges facing them.

For example, bonds that are trading below par value due to bad news (let's say 80 cents on the dollar) eventually mature back at par value as long as they have the financial resources to back up their credit worthiness.

Each person will have their own comfort level in how they deal with drawdowns. It's common advice that investors tend to do better in the long run if they are fully invested than if they were market timing.

Our own thinking on this has evolved over the years. Being fully invested and watching the market go down continuously after you have exhausted your cash reserves can be a very torturous experience.

What we like is a psychological "hedge" to maintain a certain cash level especially when markets are doing extremely well and valuations are high. This can range from anywhere from 5% to 10%, and this dry power is used sparingly and we rarely go all in. Coupled with an average dividend of 3% to 4%, this gives us considerable psychological comfort and we tend to sell holdings which are richly valued first before using this cash pile.

One can argue that this would detract from returns as the market goes over the long run. However, our own experience has taught us that most investors tend to break psychologically without a cash buffer.

As Yogi Berra said - "In theory there is no difference between theory and practice. In practice there is."

Rather than thinking about year to year returns, we recommend investors think about long term returns and spending a percentage of that instead.

As a rule of thumb, we recommend using a more conservative figure of 6% - 8% over the long run and spending up to 50% of that.

Having a good range of dividend paying stocks (and a portfolio yield of 3% to 3.5%) will help make it easier for investors to assess the amount to withdraw each year.

The idea in the end is simple - use half of the long run investment returns and re-invest the other half to compound your wealth.

One important reason why we recommend investors spend their investment income from dividends and interest and not from capital gains is that during a market drawdown, many of us will be loathed to liquidate stocks at low prices.